Tax-Efficient Withdrawal Strategies

Abstract

The authors considered an individual investor who holds a financial portfolio with funds in at least two of the following accounts: a taxable account, a tax-deferred account, and a tax-exempt account. They examined various strategies for withdrawing these funds in retirement. Conventional wisdom suggests that the investor should withdraw funds first from the taxable account, then from the tax-deferred account, and finally from the tax-exempt account. The authors provide the underlying intuition for more tax-efficient withdrawal strategies and demonstrate that these strategies can add more than three years to the portfolio’s longevity relative to the strategy suggested by the conventional wisdom.

The conventional wisdom suggests that a retiree should withdraw funds from taxable accounts until they are exhausted; then from tax-deferred accounts (TDAs), like a 401(k), until they are exhausted; and finally from tax-exempt accounts (TEAs), like a Roth 401(k). We demonstrate that the conventional wisdom is wrong.

Properly viewed, a TDA is like a partnership in which the investor effectively owns 1 – t of the partnership’s current principal, where t is the marginal tax rate when the funds are withdrawn in retirement. The government effectively owns the remaining t of the partnership. When viewed from this perspective, the after-tax value of the investor’s portion of funds in the TDA grows tax exempt. Thus, assuming a flat tax rate, a retiree’s portfolio would last precisely the same length of time if the order of withdrawals were taxable account, then TDA, then TEA—or taxable account, then TEA, then TDA.

The partnership principle is useful in devising tax-efficient withdrawal strategies in the presence of progressive tax rates. In particular, one tax-efficient withdrawal strategy is to time withdrawals from TDAs for years when those funds would be subject to an unusually low marginal tax rate for that investor. For example, suppose a taxpayer will usually be subject to a 25% marginal rate once required minimum distributions begin. Each year, she could withdraw funds from her TDA up to the top of the 15% tax bracket and then withdraw additional funds from the taxable account. After the taxable account has been exhausted and the TDA and TEA remain, she could withdraw funds from her TDA up to the top of the 15% bracket and then withdraw additional funds from her TEA. The objective is to minimize the average of marginal tax rates on the TDA withdrawals.

We also present two tax-efficient withdrawal strategies that use Roth conversions. In the first of these strategies, this same taxpayer converts sufficient funds from the TDA to a Roth IRA to fully use the 15% tax bracket. Then, she withdraws additional funds as needed to meet her spending needs from the taxable account. Once the taxable account has been exhausted, she withdraws sufficient funds each year from the TDA to fully use the 15% bracket and then withdraws additional funds from the TEA. The advantage of this strategy compared with the prior strategy is that the taxpayer has more funds in the TEA growing tax-free but fewer funds in the taxable account growing at an after-tax rate of return.

In the second tax-efficient strategy that uses the Roth conversion, the taxpayer makes two separate Roth conversions at the beginning of the first 27 retirement years, with each conversion amount being sufficient to fully use the 15% tax bracket. At the end of the year, she retains the funds in the Roth TEA with the higher returns and recharacterizes the other Roth TEA back to the TDA. This strategy allows her to avoid taxes on the returns earned in the year on the converted funds, and these funds henceforth will grow tax-free in the TEA.

In a detailed example using the 2013 federal tax brackets, we demonstrate that the most tax-efficient withdrawal strategy can add more than six years compared with a tax-inefficient strategy. In addition, the most tax-efficient withdrawal strategy can add more than three years compared with the strategy advocated by the conventional wisdom.

Sensitivity analyses confirm that the portfolio longevities increase as we progress from Strategy 1 through Strategy 5 even if we change such key assumptions as assets’ rates of return and asset allocation. In short, the ideas in the detailed example also apply to other investors and for other key assumptions.

Finally, we show the advantage of holding some funds in TDAs to meet the nontrivial probability of large tax-deductible expenses, such as medical costs, which often occur late in life. Although these TDA withdrawals are subject to taxes, the individual probably will be in a low tax bracket, possibly the 0% bracket, owing to the medical expenses.

Notes

¹ For example, the Canada Revenue Agency offers a TDA called a Registered Retirement Savings Plan (www.cra-arc.gc.ca/tx/ndvdls/tpcs/rrsp-reer/rrsps-eng.html) and a TEA called a Tax-Free Savings Account (www.cra-arc.gc.ca/tx/ndvdls/tpcs/tfsa-celi/menu-eng.html).

² Because the combined assets under management (AUM) of the three largest fund families exceeds the combined AUM of fund families ranked 6 to 100, the conventional wisdom represents the advice that millions of investors receive from the profession (see InvestmentNews 2014).

³ The capital gains can be tax-free if the taxpayer (1) is in the 10% or 15% tax bracket, (2) awaits the step-up in basis at death, or (3) donates the appreciated asset to a qualified charity. Nevertheless, in general, the individual investor receives only part of the return on stocks held in taxable accounts.

⁴ We set the retirement period at 30 years to correspond with the 30-year retirement period usually considered in the withdrawal rate literature.

⁵ A retiree who expects Congress to raise tax rates may wish to modify her acceptable “low tax rate” to reflect that expectation. For example, if she is confident that today’s tax laws will remain the same, she may be willing to withdraw or convert funds from a TDA today so long as her marginal tax rate is 25% or less. Owing to expected tax hikes, however, she may increase her acceptable “low tax rate” to 28%.

⁶ The $99,271.67 consists of $11,500, $8,925, $27,325, and $51,521.67, which are taxed at 0%, 10%, 15%, and 25%, respectively. The after-tax amounts total $81,400.

⁷ In a more detailed spreadsheet, we calculated her taxes on bonds held in the taxable account for Years 1–3 and 17–30. In addition, we calculated her after-tax returns on this account for Years 4–16. This more precise calculation reduced her portfolio’s longevity to 29.66 years. Thus, our simplifying assumptions understate the additional longevity that is possible under a tax-efficient withdrawal strategy.

⁸ In Years 1–3, she owes $722.80, $469.23, and $206.52 in taxes on interest earned on the taxable account. Given these details, her portfolio provides funds for 33.09 years, a little less than suggested in Table 2.

⁹ In this example, the retiree does not meet her RMD in Years 6–8. If we assume that she retires at 62, however, there is no violation of the RMD rules. But if she retires at 62, her standard deduction is $1,500 less before age 65 (owing to the loss of the additional standard deduction for age). This change causes the tax-free withdrawal amount and the withdrawal amount to the top of the 15% tax bracket to differ on each side of age 65. To keep the example sufficiently simple for readers to follow, we avoid this complexity and assume that she retires at 65. This assumption does not materially affect the longevity of Strategy 2 as compared with the longevities of the other strategies.

¹⁰ After the conversion at the beginning of Year 7, the TEA has $674,403 in Strategy 4 (an ending balance in Year 6 of $626,653 + $47,750) but only $297,259 in Strategy 3.

¹¹ Target retirement date funds provide target asset allocations for investors by year of retirement. Fidelity and Vanguard are the two largest mutual fund families. The 2015 Fidelity Freedom Fund and the 2015 Vanguard Target Retirement Fund currently recommend, respectively, stock allocations of 56% and 52% for typical individuals retiring in 2015, and Fidelity’s and Vanguard’s income funds, which are intended for individuals who are at least 14 and 7 years past retirement, recommend 24% and 30% stock allocations. Large-cap stocks and five-year Treasuries have produced 6.8% and 2.4% real returns over 1926–2013 (Ibbotson Associates 2014). But these returns ignore the costs of running mutual funds, including the funds’ expense ratios and transaction costs. Assuming total annual costs of 0%, 0.25%, and 0.5%, these historical returns are consistent with a 4% real return and stock asset allocations of 36%, 42%, and 48%. Thus, the 4% nominal return with 0% inflation rate is consistent with historical real returns on stock/bond portfolios with asset allocations recommended for typical retirees.

¹² As of 30 June 2014, the real return on five-year Treasury Inflation-Protected Securities (TIPS) was 0.6%. Assuming that the geometric average equity risk premium is near its historic 4.8% level, the real return on a 50%/50% stock/bond portfolio would be about 3%. See Ibbotson Associates (2014).

¹³ At the beginning of Years 1–24, the retiree converts two separate TDAs worth $47,750 to a Roth TEA and recharacterizes the lower-value TEA at the end of the year. In Years 25–26, he withdraws $47,750 from the TDA to take his taxable income to the top of the 15% bracket plus additional funds from the TEA to meet his spending goal. Thereafter, because his TDA balance is relatively low, he withdraws $20,425 from the TDA to take his taxable income to the top of the 10% bracket and also withdraws the remaining funds from the TEA.

¹⁴ Her AGI and medical expenses would be $81,400. Medical expenses exceeding 10% of AGI would be tax deductible. The $8,140 of AGI after the deduction of medical expenses would likely be less than her personal exemption and other itemized expenses (state income or sales taxes, real estate taxes, mortgage interest, charitable contributions, etc.). So, her taxes would likely be zero or trivial.